The expected rate of return on stockholders’ equity indicates how efficiently a company uses owner investment to generate revenue. The higher the rate of return on stockholders’ equity, the better it is for the company’s stockholders as a high rate of return means the company can rely less on debt to finance activities. The rate of return on stockholders’ equity is calculated by dividing average stockholders’ equity by net income.
View the company’s income statement to determine net income. A company’s net income equals its pretax income minus federal, state and local taxes. Net income is transferred from an income statement to the stockholders’ equity section of the company’s balance sheet. A company may distribute net income to shareholders in the form of dividends, or it can reinvest the money in the company’s retained earnings account.
Compute the average stockholders’ equity. Add the company’s beginning stockholders’ equity with the ending stockholders’ amount indicated on the balance sheet. Assume, for example, a company has beginning stockholders' equity of $200,000, and ending stockholders’ equity of $275,000. Add $200,000 and $275,000 to get $475,000. Divide $475,000 by two which amounts to $237,500. This number represents the company’s average stockholders’ equity.
Divide net income by average stockholders’ equity. The result indicates the company’s expected rate of return on stockholders’ equity. For instance, a company with net income of $59,000 and average stockholders’ equity of $237,500 has a return on stockholders’ equity equal to 0.248 or roughly 25 percent (59,000/237,500 = 0.248). Compare the company’s return on stockholders’ equity with other firms in the same industry to assess the overall financial health of the business.
Items you will need
- Income Statement
- Balance Sheet